More than one hundred billion dollars (US) is currently invested in hedge funds, private investment funds with broad mandates and powers, including the ability to use leverage, take short positions and charge performance-related fees. The popularity of such funds is driven in part by their investment flexibility and by a desire for diversification on the part of investors. As a group, hedge funds invest in a wide variety of asset classes, including world equity (stock) markets and commercial (non-equity) asset classes such as global bonds, currencies and commodities. (An asset class is simply a set of similar assets such as stocks, bonds, currencies, and commodities, including all securities or contracts based on the assets such as futures and forward contracts.) While investment strategies used in equity markets overwhelmingly involve buying individual stocks or groups of stocks, the investment strategies used in these other asset classes are said to be “opportunistic” in the sense that positions are much more likely to vary over time in both size and direction. For example, the funds may have long bond positions when interest rates are expected to decline, and short bond positions when interest rates are expected to rise. (A long position refers to a purchase, or agreement to purchase, a particular asset, while a short position refers to a sale or agreement to sell.) Since the returns from investing in bonds, currencies and commodities tend to be uncorrelated with equity returns, the varied nature of hedge funds' investment profile has great appeal for investors in search of diversification beyond traditional assets.
A major obstacle to further growth in hedge fund investments, particularly for institutions, is the lack of performance benchmarks. Unlike equity funds, for example, where a number of equity indices are available for use in evaluating performance, hedge funds operate in a benchmark vacuum. Ironically, it is the same asset categories that are the source of so much diversification that pose the difficulties to developing a valid benchmark. The common view in financial circles is that the dynamic nature of bond, currency and commodity investments (sometimes long, sometimes short) present difficulties for indices that are insurmountable.
Nobel Laureate William F. Sharpe proposed in a 1992 article, Asset Allocation: Management Style and Performance Measurement (Journal of Portfolio Management, Winter 1992), that the returns of mutual funds could be explained by a linear combination of a small number of factors. Sharpe was concerned with mutual funds that invested in traditional asset classes, namely, stocks and bonds, and did not use leverage or take short positions. The explanatory factors he uncovered were the traditional investment benchmarks such as the S&P 500, or indices of small capitalization stocks or growth stocks. Critically, each of these benchmarks is based on market prices of the securities included in the benchmark.
Sharpe's article was the genesis of “style analysis,” the attempt to categorize and better evaluate the performance of different investment managers. Other authors have attempted to extend style analysis beyond managers who invest in equities to those who invest in asset classes such as global bonds, currencies, and commodities, an area commonly known as “alternative investments.” This is the domain of hedge funds and commodity trading advisors (CTAs).
Application of Sharpe's method to alternative investment managers is hampered by the nature of the investment activity. Hedge fund managers and CTA's typically take both long and short positions in the markets in which they trade, so direct application of buy and hold benchmarks cannot capture their investment returns. As a consequence, attempts to benchmark the performance of hedge fund managers and CTA's have tended to degenerate into indices that combine the investment returns of similar managers, called “manager benchmarks.” These indices simply bypass the requirement that a useful benchmark be based directly on market prices.
There is a need for a system that provides benchmarks based on market prices for asset classes other than equity. The present invention satisfies this and other needs.